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Merk: Are There Any ‘Safe’ Assets Left?

In a recent blog, I contemplated the odds that we might be facing a market crash. Today, I’m looking into whether there’s a place to hide for investors looking for “safety” in turbulent times.

Equities might be considered the ultimate “risk” asset. When the glass is considered to be half full, when investors want to put money at risk, equities have historically been the place where investors have flocked in search of attractive returns. The downside, of course, is that when the tide turns, equities might deliver outsized losses.

Defensive investors have historically had a bias towards bonds. However, bonds are not risk-free as they carry interest rate and credit risk. Recent months have been a stark reminder that bond prices can fall as interest rates have crept up. In fact, I have cautioned in the past that the biggest threat we might be facing is economic growth, as higher rates will make it more challenging to finance the government’s deficits. It turns out that volatility in the bond market this year has been higher than that in the equity markets, throwing the ultimate risk asset off its throne.

Safe isn't what it used to be

Cash, in contrast, is historically considered the ultimate safe haven. But cash isn’t what it used to be. On the one hand, given negative real interest rates, one is almost certain to lose purchasing power holding cash over time.

And on the other hand, those seeking higher returns than those available through Treasury Bills (3-Month Treasury Bills are currently yielding a mere annualized 0.05%) have to take on additional risks. In the summer of 2011, for example, approximately half the assets of U.S. prime money markets funds were invested in U.S. dollar denominated commercial paper issued by European banks; some firms even had three quarters invested in short-term paper of such banks, many of them in the spotlight as the fear of contagion was flaring up in the eurozone’s debt crisis.

Similarly now, many investors looking to boost their returns on cash, oftentimes accept more credit risk. We are not predicting a rerun of 2008, but simply pointing out that if one receives a return higher than available in Treasury Bills, odds are that there is some risk associated with it.

Gold is not risk-free

In contemplating the odds of a crash, I drew parallels to the market plunge in the price of gold and pointed out such corrections can happen in equities as much as in gold. I also disclosed that I personally own gold. Numerous readers interpreted that as an endorsement of gold as a safe haven. Let me be absolutely clear: even if I can make an investment case for gold, risk-free it certainly is not.

Surely gold, when properly held, might be free of counterparty risk, but goods and services are generally priced in U.S. dollars (or another currency for those living abroad). As such, gold is volatile when priced in U.S. dollars. At times, as this year has reminded us, the volatility can be substantial. Gold is typically less volatile than other commodities, but again, risk free it is not.

The conclusion here is that there is no such thing as a risk-free asset anymore. In my assessment, this is a trend fostered by central banks the world all over, as cash is at risk of losing its function as a store of value.

What does it mean for investors? It suggests that investors that try to construct an “efficient” portfolio should throw out the notion that there is a risk-free asset. In less technical terms, it means investors must not be complacent, but actively manage their risk. Investors don’t need to become day traders, but they ought to embrace that we live in an unstable world. Sophisticated investors can thrive in such an environment, but the mom and pop saver is at risk of coming out worse off, contributing to an increase in the wealth gap over time.